Contending that “the vast majority of the market” is making one set of assumptions about the economy based primarily on past experiences, the Co-CIO, Senior Co-Portfolio Manager and Head of Long/Short Strategies explained that he strongly disagreed with the “fear of peaking economic momentum.”
“The combination of stunning policy support and the fact that the private sector is in such robust health makes it very hard to think that this is not an economic cycle that has at least a couple of years in it. Just the restocking cycle alone should last through 2022 and possibly into 2023,” he said.
Further, Grant said, “It is too early to call the top in S&P 500 earnings. I think earnings are going to continue to trend higher at an almost historic pace between now and the middle of next year…this is a remarkably favorable fundamental setting.
“S&P estimates are between $210 and $220," noted Grant. In a year’s time, investors will be looking at forward earnings of $230 to $240. If the expansion can continue, peak earnings should be above $250 a share. That puts the S&P today at just over a 16 times EPS handle.
“There are parts of the market, which are bubbles and are valued egregiously,” he acknowledged. “But you can’t look at that number of just over 16 times peak earnings and say the world’s gone crazy.”
Grant organized his remarks around three points:
Investors are unsettled, Grant said, in part because of the historic nature of the COVID-19 pandemic and likely also due to uncertainty about where the market is headed.
Deceleration in many leading indicators should not be mistaken for late cycle dynamics, according to Grant.
“It is absolutely true that many measures of activity are peaking in terms of momentum and rate of growth. That’s simply because those rates of growth are historic...But it’s equally important to understand that rates of growth always peak in the 12 to 18 months following the recession. And yet the economic cycle and the equity cycle can go on for years, and has historically done so,” said Grant.
To track progress, pay attention to these two indicators.
Earnings. Many economic indicators, particularly those associated with the bond market, are distorted by the extreme nature of the COVID shutdown a year ago, as well as by unprecedented Fed intervention and government stimulus. Don’t be misguided by them, Grant said. A better measure is the trend in S&P 500 earnings. A year ago, S&P earnings troughed at $160 a share. The run rate now is close to $220 a share.In other words, he said, “at the depth of the COVID crisis in markets, the S&P was trading not much more than 10 times forward earnings of the highest quality risk asset in the world with a free cash flow yield, therefore, of more than 10%. The point is: Everything that’s happened in equity risk assets has fundamentally followed what’s happened in earnings estimates. And the trend in S&P earnings has been decisive for the past year.”
Bitcoin as a barometer. The amount of liquidity in the system is “stunning.” Former Federal Reserve Chairman Ben Bernanke grew the Fed’s balance sheet from 5% to 10% of the U.S. economy after 2008. Now it’s at 35%. The Fed balance sheet prior to the pandemic was about $4 trillion, it’s since doubled and the Fed’s tapering plans call for it to rise another $9 trillion by this time next year.“Despite all these concerns about slowing liquidity, I think what that argument misses is just how massive the liquidity backdrop is today,” said Grant. Keep your eye on bitcoin—the “tulip mania of our generation,” he said. “Until bitcoin more severely rolls over and stays low, I think we have to go with the positive liquidity thesis.”
Yet to be determined, he said, is the “degree of deceleration we’ll see between now and the second half of next year and whether the economic cycle stagnates much like it did after 2009. Or, does activity settle down at a normalized rate that’s fundamentally higher than the pre-pandemic period?”
Grant and team expect a “more typical and sustained cycle underpinned by three factors. One is still very easy central bank policies. Two is labor market recovery. And three is a remarkable private economy, and very healthy consumer and corporate sectors.”
Grant asked, “After all the disruption that we’ve seen, is four quarters enough to address supply chain disruption or normalization or back to work?
“What’s going on in the economy is much more substantial than simply refilling the supply chains. We think supply chains are disrupted because they have to be rebuilt for a fundamentally higher level of nominal demand. If that conclusion is correct, then we’re heading into a real investment cycle. And it is not something that can simply unfold or be resolved in just four quarters.”
The consumer, Grant said, may be on the brink of finally achieving the liftoff that they failed to achieve since the Great Financial Crisis.
Grant believes that the U.S. is “very close if not at a climax of the current wave of the Delta virus.” Elsewhere, he said, much of the reopening is still ahead. But by this time next year, he expects the world to be over the pandemic. A two-year duration is consistent with previous pandemics.
“Ironically,” he said, “the pandemic fears are the wall of worry that the market is climbing. And it is unexpectedly the support for risk assets because it ensures that policy support remains fully behind the economy.”
But, Grant recognized, “the bond market is giving off a very different signal…And my simple answer for that is I think the Fed has cornered the long-term bond market. And it currently accounts for 50% to 60% of all activity in 10-year Treasuries.”
“If the deceleration in the leading indicators goes all the way back to neutral in the next few quarters and therefore leads to a reversal of the increase in earnings estimates that we’ve seen,” he said, “then the bond market is right and I am wrong.”
A global fund with a long-time bias toward U.S. equities, CPLIX’s positioning reflects Grant’s expectations of reflation and “a real investment cycle.”
“Whenever I see everyone standing on one side of the boat, I want to think very hard about ensuring that I have at least one foot on the other side of the boat,” said Grant. “And that alternative view to the future is a more reflationary path. At minimum, it argues for balance in your portfolio.”
As such, he said, “two-thirds of the long book is positioned to benefit from ongoing cyclical recovery, not just cyclical exposure but holdings in sectors such as industrials, financials, consumer durables—industries where operating margins and therefore earnings can move materially higher.
“We haven’t given up on quality growth stocks that outperformed in 2020 relative to the general market. About one-third of the long book is in what we would call well understood, well positioned growth, which still has favorable investor sentiment.”
“But," he said, "the important point is that that balance is very different than the benchmark composition. The [S&P 500] is more two-thirds growth and one-third cyclical recovery."
Grant concluded his comments by saying, “Now, you might say that it all comes down to the U.S. 10-year yield. I’d agree with you. What is remarkable today is that when we analyze the sensitivity of the S&P and the components of the S&P to the U.S. 10-year yield, we see a greater proportion of the S&P today is highly correlated to the daily changes in the U.S. 10-year yield than we’ve ever seen in the last two decades.
“In addition, that portion of the S&P that’s highly correlated to the U.S. 10-year yield is more highly valued relative to the rest of the market than it has ever been. When we say it all comes down to the direction of the U.S. 10-year yield, the market is confirming that,” he said.
This current opportunity to “make hay” will be finite, according to Grant. By next spring, he said, “the bulk of the risk-on story in equities will be in the price. From that point, future nominal returns in equities become much lower.” The team anticipates the possibility of “a major bear market” in 2023-2024.
Investment professionals, for more information about Grant’s perspective or CPLIX, contact your Calamos Investment Consultant at 888-571-2567 or firstname.lastname@example.org.
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